Regulations are set up to prevent or control abuses such as fraud, corruption, monopoly, health hazard, environmental pollution, and so on. The practical question is: How much regulation do we need? The answer depends on your philosophy and self-interest. Some say as little as possible. Some advocate as much as necessary. Some prefer the middle ground.
The banking sector needs special regulations because it may bring down the entire economy if something goes wrong. Why? The banks fuel the modern economy through circulating money and offering credits. The banking industry is a symbol of trust because it requires people to deposit their monies to provide it with the capital to operate. If the public trust is broken, there will be a run on the bank, and the whole economy will come to a halt. In the US, a major bank run happened in 1929 followed by the Great Depression. The financial meltdown of 2008 almost brought down the big banks, precipitating the Great Recession that we are still suffering today.
In addition to the banks’ crucial role in the economy, there is the panic factor that makes them even more crucial. If a big manufacturing firm fails, it may bring some shocks to the economy, but never panic. If a major bank fails, it sets off a public panic that will spread throughout the industry and the economy. The panic contagion will also spread overseas quickly thus engulfing the whole world. The fall of Bear Stearns and Lehman Brothers in 2008 testifies to the panic contagion.
There exist basically two kinds of banks: commercial and investment. The former consists of big names such as Bank of America, Citbank, JPMorgan Chase, etc. Insurance companies such as AIG are also treated as commercial banks by the government for regulation purpose. On the other hand, the investment banks consist of Goldman Sachs, Morgan Stanley, and discount brokers such as Charles Schwab, etc. Each type of bank is regulated by a special set of regulations. The basic differences between the two are as follows.
Commercial banks accept public deposits in the form of checking, saving and retirement accounts. The US government guarantees each account in the form of Federal Deposit Insurance. Should a bank fail, the government would indemnify each account holder up to the maximum allowed by law. The backing of the government requires the commercial banks to be conservative in their practices. In other words, the commercial banks’ sole business is to take deposits and make loans. They earn the profit margins between the interests charged to borrowers and those paid to depositors. They are forbidden to engage in risky ventures such as underwriting or trading stocks, derivatives, etc, as stipulated in the Glass-Steagall Banking Act of 1933. This is to prevent public panic in case of a bank failure. It also prevents the commercial banks to transfer high-risk losses to the government through the deposit insurance scheme.
On the other hand, investment banks are given more latitudes for operation. Their clients are investors ready to take big risks in underwriting new companies, stocks, and other financial products. The government does not offer investment banks any deposit insurance due to the high risks involved. Investment banks are allowed to fail because they only affect a small segment of the population, that is, the high income groups who can afford to lose, and are supposed to know the high risks of their investments.
The Glass-Steagall Banking Act has set up the different rules as described above between commercial and investment banks. Since enactment in 1933, it had specifically forbidden commercial banks to engage in risky and speculative ventures. But something changed in 1999.
In 1999, the US Congress voted to repeal the Glass-Steagall Act, and to replace it with the Gramm-Leach-Bliley Act. Due to intense lobby (or bribery?) by the banking sector, the distinction between commercial and investment banks were almost completely torn down. The result is that commercial banks can now use people’ deposits to do risky business such as trading securities, derivatives, etc. In addition, investment banks and brokerage companies can now accept deposits from the public by opening checking or retirement accounts. The consequences are: The banks run wild in pursuit of profits. The public loses protection. The government ends up footing the bill, amounting to $750 billion to bail out AIG and the big commercial banks to prevent a banking collapse in 2008. The moment of truth came as being played out in the financial meltdown of 2008. The story does not end there. In early May of 2012, JPMorgan Chase announced a loss of more than $2 billion in trading risky derivatives.
At present, there is a clamor for the Volcker Rule that aims to restore the crucial distinction between commercial and investment banks as stipulated in the long-standing Glass-Steagall Act. For those who want as little regulation as possible for the banking sector, the 2008 financial meltdown is the biggest lesson that has not been learned. The 9 million jobs lost in the aftermath have been totally forgotten. The slow recovery of the US economy right now is due to the bank’ subprime mortgages that wrecked the housing market. The 2008 financial meltdown pushed the world to the brink of economic collapse. Sadly, it is not regarded as a teachable moment for future generations. It seems so far away after a few years. Are we suffering from amnesia or what?